The Canadian bond market moved in a seesaw pattern in February, with yields rising and then falling twice in the month. The bond market remained in the trading range that began in December, once the market had initially reacted to the surprise U.S. presidential election result. The market’s focus remained on the new U.S. administration, as the correlation between Canadian and U.S. bond yields was very high. Investors were hoping for greater clarity on the new government’s fiscal, regulatory and trade policies. The economic consensus remained optimistic, with risk premia (yield spreads) for provincial and corporate bonds shrinking and the U.S. stock market continuing its post-election rally. The FTSE TMX Canada Universe Bond index returned 0.96% in February.
Canadian economic data in February was better than expected, but was not sufficient to cause the Bank of Canada (BOC) to adjust its monetary policy. Of note, the unemployment rate fell to 6.8% from 6.9% a month earlier, as robust job creation more than offset an increase in the participation rate. Manufacturing sales and wholesale trade were stronger than expected. Retail sales disappointed, following four consecutive months of gains. Higher gas prices and new carbon taxes pushed the inflation rate up to 2.1% from 1.5%, but the BOC chose to ignore the increase. Canada had its second consecutive monthly trade surplus, due primarily to higher prices for its energy exports. Non-energy exports fell during the month and are 2.9% lower from a year ago, contrary to the BOC’s projections for an increase.
U.S. economic data was mixed, but on balance was supportive of a further rate increases by the Federal Reserve (Fed). The unemployment rate rose to 4.8% from 4.7%, as the optimistic economic environment encouraged more people to look for work. Job creation was quite good, but not strong enough to offset the rising participation rate. Early in the month, the Fed left rates unchanged, but several subsequent speeches by officials hinted that there might be a rate hike at the Fed’s March 15th meeting. Inflation rose to 2.5% from 2.1%, raising a concern for the Fed as the U.S. economy is at full employment.
International events appeared to have limited effect on Canadian bonds in February. This was somewhat surprising given the potential that some of these developments can cause significant market volatility in the next month or two. While investors could be forgiven their complacency over yet another Greek bailout negotiation, the upcoming elections in the Netherlands (March 15) and France (April 23/May 7) in which Euro-sceptics are leading the respective polls, could cause marked volatility in both equity and bond markets.
The Canadian yield curve edged lower in February with 2 and 30-year benchmark Canada bond yields declining 3 and 7 basis points, respectively. The largest decline came at the 10-year term, which saw yields drop 13 basis points. The shift in Canadian yields echoed very similar moves in the U.S. yield curve. The federal sector earned 0.59% in the month as the small declines in yields produced small price gains. The provincial sector returned 1.30%, with the average yield spread of provincial bonds narrowing 6 basis points, resulting in better price appreciation than with federal issues. The investment grade corporate sector earned 0.99%. Corporate yield spreads narrowed by an average 9 basis points, as new fixed rate issues of $5.8 billion failed to satisfy investor demand. The change in corporate yield spreads was greater than provincial spreads, but corporates’ shorter average durations meant they had relatively smaller price gains. Coincidentally, high yield corporate bonds also returned 0.99% in February. Real return bonds ignored the uptick in inflation and returned only 0.69% in the month. Preferred shares earned 1.49% in the period.
NexGen Canadian Bond Fund
The Fund enjoyed good results in February, outperforming the benchmark. Favourable security selection improved returns as both existing holdings and new purchases enjoyed better than average narrowing of yield spreads. Yield curve positioning, which overweighted mid-term issues and underweighted long- term ones, also added to the Fund’s performance. The Fund’s emphasis on the corporate sector further increased results as the sector had strong returns in the month. Interest rate anticipation was also a small positive factor to this month’s performance.
Noteworthy transactions in February included the purchases of three new issues: a 12-year Bruce Power LP bond, a 30-year Bell Canada bond, and a 7-year issue of Superior Plus. The Cadillac Fairview Finance holding was switched into a Bank of Montreal deposit note to improve yield by 15 basis points for only a four month extension in term. The Inter Pipeline holding was extended by 1.75 years to improve yield by 27 basis points. In addition, the Northwest Redwater holding was sold in anticipation that upcoming issuance would result in wider yield spreads and the Goldman Sachs bonds were sold once their April redemption was announced.
Market Outlook and Strategy
The BOC has reaffirmed its stand-pat monetary policy at the time of writing. Citing persistent economic slack and dismissing the recent jump in inflation as temporary, the BOC left its interest rate targets unchanged. It appears that the BOC is unlikely to raise rates for the next 12 to 18 months. However, without a significant weakening of Canadian economic activity, the BOC is also unlikely to reduce rates from current levels.
In contrast to the BOC, the Fed appears likely to raise its trendsetting interest rates at its March 15th meeting. Several Fed speakers in recent weeks have hinted at the likelihood of the increase, so the markets will not be surprised if it occurs. The last increase in December did not have a noticeable impact on the bond market, because it had been anticipated by investors and we expect that an increase this month will similarly have a limited effect on bonds. However, should the accompanying statement from the Fed suggest a more aggressive path of rate increases in the future, bonds may sell off. That seems unlikely, as the Fed along with everyone else is waiting to learn specifics of the new administration’s economic policies.
Offsetting the risk of lower bond prices because of the Fed move are several factors that have been mostly ignored by investors to date. First, a series of upcoming European elections in which anti-EU candidates are leading the respective polls. On March 15th, coincidental with the Fed meeting, the Netherlands are holding national elections and in late April and early May, the French are holding presidential elections that could result in further worries about the EU’s viability. This could result in a flight-to-safety bid for U.S. and Canadian bonds. European election concerns have already caused 2-year German Bund yields to fall further into negative territory, hitting a remarkable -0.94%. Also in March, the U.K. government is likely to give formal notice that it will leave the EU. A second potential market-moving event for bonds would be a stock market correction. Equities, particularly in the U.S. have had remarkable gains since the presidential election and valuations appear risky by historical measures. When stock markets correct, bonds tend to be viewed as a safe haven. A third potential market-moving factor for bond investors are the U.S. administration’s new trade policies. If the U.S. becomes significantly more protectionist, this will have negative implications for both the Canadian and U.S. economies.
Currently, portfolio durations are somewhat shorter than their respective benchmarks. We anticipate adjusting durations to be closer to neutral in the near term as we approach March 15th. The current yield curve positioning means the portfolio will benefit from yield curve steepening, which seems appropriate given the risk that longer-term U.S. bond yields will rise and pull long-term Canadian yields higher. Corporate bonds’ yield pickup remains attractive so we continue to overweight the sector. However, the tightening of yield spreads over the last year has made corporate bonds closer to fair value, so we are considering a reduction in corporate holdings. For clients that hold preferred shares, they continue to offer significantly better yields than bonds.
For more information about NexGen Canadian Bond Funds, please contact your financial advisor.
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This release may contain “forward-looking statements” which reflect the current expectations of NGAM Canada LP and/or its sub-advisor, J. Zechner Associates Inc. (“J. Zechner”). These statements reflect the applicable management’s current beliefs with respect to future events and are based on information currently available to such management. Forward-looking statements involve significant known and unknown risks, uncertainties and assumptions. Many factors could cause actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements including, without limitation, those listed under the heading “Risk Factors” in the NGAM Canada LP NexGen Funds prospectus, which is available on NGAM Canada LP’s website and on SEDAR at www.sedar.com. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results, performance or achievements could vary materially from those expressed or implied by the forward-looking statements contained in this release. Although the forward-looking statements contained in this release are based upon what NGAM Canada LP and/or J. Zechner believes to be reasonable assumptions, NGAM Canada LP and J. Zechner cannot assure investors that actual results, performance or achievements will be consistent with these forward-looking statements. These forward-looking statements are made as of the date of this release and NGAM Canada LP and J. Zechner do not assume any obligation to update or revise them to reflect new events or circumstances.
NGAM Canada LP is the manager of the Fund and is an affiliate of Natixis Global Asset Management S.A.